SPECIAL REPORT: Outsourcing to China, Part 2

Intellectual Property Concerns

There's just one way to describe the record of intellectual property (IP) rights protection in China: appalling. Pirated DVDs and fake branded goods are ubiquitous on the streets, and — more relevantly — up to 98% of software products sold in China are unlicensed or pirated copies. There's almost no cultural awareness for IP rights. It's been said that in China, anything that can be profitably copied will be.

The slightly promising news is that China has made great strides since joining the World Trade Organization in 2001. Today, its laws meet or exceed the standards set by the principal international IP treaties, and recent changes have lowered the threshold for bringing suit against an infringer. A number of recent cases resolved on the side of IP, setting legal precedents that buttress legal recourse as well as, presumably, help as a deterrent to would-be infringers.

Unfortunately, implementation and enforcement of existing laws are still lacking. "Though we have observed commitment on the part of many central government officials to tackle the problem, enforcement measures taken to date have not been sufficient to deter massive IP rights infringements," according to a U.S. Department of Commerce guide on protecting IP in China.

Factors undermining enforcement measures include "China's reliance on administrative instead of criminal measures to combat IP infringements, corruption and local protectionism at the provincial levels, limited resources and training for enforcement officials, and lack of public education regarding the economic and social impact of counterfeiting and piracy."

It all boils down to is this: The risk of IP rights infringement is serious. It behooves any outsourcing manager going to China to take aggressive measures to minimize it.

This begins with proper due diligence. To state the obvious, the process begins with identifying companies with clean records. In this regard, the US Department of Commerce and the US Commercial Service is a great resource, though there is some value to the word-of-mouth methodology.

On its Web site one sizable company vouches that it will "obey all internationally accepted IP law in accordance with WTO agreement [sic]." But are the words backed up by competent and aggressive actions? Has the company adopted clear and robust physical security measures?

Bleum, for example, has a "shadow group" of developers who are given financial incentives to uncover vulnerabilities in software developed by the lead development team. It backs this up with staff education on property rights and ethics.

"Property rights and ethics are new concepts to them and they need to be made aware of them," explained Mr. Rongley. "We try to make them understand that the nature of this business is such that just one security breach would destroy us. We tell them it is not just about one person, but all 100 people can lose their jobs if they do that. So they should think about that before making a quick buck of it."

He advises: "Look at the precautions the vendor has [taken] to protect you. How good is their employment and IPR contract? What is their security framework? There is never perfect security. It is a matter of cost, but basically, the thing to do is eliminate all but the James Bond kind of heist… It is up to the customer [to determine] how much security they need. In the end, at the most basic level, the way to do it is to compartmentalize code and to prosecute aggressively."

Companies can further protect themselves by building effective legal protections into their contracts to address egregious IP violations on the part of a service provider. Though not necessarily worried that Neusoft would act with ill intent, the Japanese clients of the Shenyang-based outsourcing vendor nevertheless have contracts that are designed to be enforceable in both Japan and China with an avenue for arbitration with a third party under Hong Kong law.

As a final risk-mitigation measure, don't have the entire application developed in China. "We don't give them every piece of the puzzle," according to Sebastian Risse, director of product development of CommerceQuest Inc., who has outsourced to China through service provider Freeborders.

Wipro, which has established development centers in China, treads carefully along a similar line. According to Sudip Banerjee, president of enterprise solutions, the company passes on only what is absolutely needed and what is required for local implementation.

Lost in Translation

Different people say different things about the English language proficiency of Chinese engineers. No surprise that supporters of the wonders of the English skills of the Chinese citizenry tend to work in service providers; naysayers tend to be finicky analysts. But it is safe to say that English is still an impediment to the Chinese software industry's expansion into English-speaking markets. It might be pointed out that though a project can get by well enough with broken English, documentation riddled with bad English has practical implications.

The language barrier isn't insurmountable. The number of companies outsourcing to China can attest to it. And there are companies chockfull with project managers and programmers proficient in English. The key is establishing formal communication processes with workers in China — as CommerceQuest did — as a way to mitigate language issues.

And here's a tidbit that hints to the strength of the China as a future outsourcing destination: there are more people in China learning English than there are people learning it in the US. The education begins in the third grade and continues through college. The Chinese government is investing more than $5.4 billion in English education in universities.

Culture

Though the business culture is shifting towards one that is more recognizable to Western practitioners, there are still differences — some more remarkable than others — that can affect the workings and outcome of an outsourcing relationship.

This may sound extreme, but a longtime business entrepreneur once lamented that "in China, it is signal right, turn left."

Laurence Brahm, author of numerous books on China, might be accused of being a Cassandra, but he was not exactly off the point when he wrote, "When Yes means No! (Or Yes or Maybe!)," that "'yes' in China may be the first word of agreement, but is not always the last word in negotiations. ÔYes' is often simply another way of saying, ÔLet's begin to talk seriously'… For the Western party, a contract is a contract and the obligations of the parties are those obligations spelled out therein. Western culture is goal-oriented. Negotiations are simply a process through which the final goal — the contract — is reached. Chinese society is process-oriented. Consequently, their negotiations often involve understandings and intentions which are not spelled out in the contract."

Negotiations habits aside, cultural issues that can affect the work process include how it is — in general — inappropriate to question people with seniority. It's not all negative, of course. If we can generalize, cultural traits that can be attributed to the Chinese include hardworking, resourceful, and quick of mind.

Supportive Government and Policy

The Chinese government has been playing the role of a handmaid and sometime-matriarch to the Chinese software industry.

It envisions software exports to increase to $5 billion in 2005, and it has targets to develop key domestic software companies with over $602 million in sales revenues. To this end, it established numerous software parks as company incubators. Other measures include: tax incentives such as zero duty on tax items related to IT products, enforcing with greater urgency IP laws, reimbursement of funds spent on acquiring CMM certification, and preferential income tax treatment for newly established software companies. Towards, the latter, companies don't pay income tax for the first two years of their operation and enjoy a tax discount of 50% on standard tax rates for the three years after.

Aside from massive investment in the education system, it has also- in partnership with U.S. technology firms such as Cisco Systems, Microsoft and IBM — established 35 national schools specifically for software training in technologies such as .Net, Linux, Java and Web services. The goal is to have 800,000 trained software professionals by the end of 2005.

It should be pointed out that the governmental support and involvement is not without potential pitfalls. Stephen Lane, an analyst at Aberdeen Group Inc. in Boston wrote that "government involvement in the traditionally wide open world of software development is a double-edged sword. "This is a government that shuts down Web sites, remember."

The 2003 Government Procurement Law is a concrete example. The law, meant to boost the software industry, requires the government and its agencies to procure from domestic suppliers where possible for all software needs. This law, according to the US Information Technology Office, has deeply disaffected non-Chinese software companies.

Economic Environment and Outsourcing Relationship as Entry into Market

China's economic environment is large, booming and for the most part stable. And there are great stakes in keeping it that way — among them the fear that the country would devolve into anarchy if the government doesn't deliver the economic goods.

Weaknesses in the economic sectors include a banking sector that is heavily burdened with bad debt, over-investment and overcapacity in some sectors in the economy and corruption that undermines the efficient allocation of economic goods. Also, further increase in foreign exchange holdings from capital inflows and trade surplus could complicate monetary management, according to the World Bank. None of these, for the purposes of IT outsourcing, are cause for great alarm yet.

In short, the economic environment is more a plus factor than a negative factor.

On the positive side, "another reason to consider China for IT service is the 1.3 billion people marketplace that China constitutes," said Stefan Klotz in his study titled The future of China's software outsourcing industry. "Some examples of sectors that need a remake of their IT-infrastructure are banking and insurance. This opens up further opportunities for foreign software vendors." Domestic software sales in China is $17.3 billion (compared to India's $3 billion).

A foreign company with established relationships in China has a better chance of getting lucrative Chinese contracts. There is no outright prejudice for foreign companies already in the Chinese market but it is not known to hurt. Also, a company that already has experience outsourcing to China might have a better understanding of the machinations of the Middle Kingdom. The reverse is true too. Those companies already outsourcing to China in the manufacturing sector will probably have greater success in sending IT work there too.

Also, as companies expand into China, outsourcing to a local vendor becomes desirable as ground support for operations there.

Cost: But is it Really Cheaper?

China's reputation as the Mother of all bargain basements in the world of manufacturing has led many to assume also that IT services can be had from the country at similar prices. Much of it is not unfounded since China does have an enormous labor supply and, in terms of cost per unit of engineer, looks cheaper than India.

But is it — when all is reckoned – really cheaper than India? This question is specific to India since the country is the frontrunner as an IT offshoring destination, and China is slated by many analysts and observers to be the primary alternative to India.

Generally, when somebody says China is cheaper, that typically refers only to the cost of an engineer or manager. This cost looks only at the dollar outlay. But China's labor pool is, generally speaking, of the cheap and not-so-good variety. Factoring in the intangibles such as level of skills, quality, efficiency, experience and training period needed to get staff up to par, the differences between China and India begin to disappear.

Wipro's Mr. Banerjee, which established a development center (with a staff "in the hundreds") in Shanghai to implement software development activities for customers with a presence in China, would agree. He disputed the notion that it might be cheaper to do work in China, saying "I don't believe it's true." By his own reckoning, China is about 10% to 15% less expensive in terms of programmer cost, but 25% more expensive when it comes to supervisory staff, project lead and project managers. Accordingly, he reckoned that the net cost between projects with a 10-person or 20-person team would be the same.

In fact, according to Bleum's Mr. Rongley, getting the best in China won't be as economical as people expect it to be. "Most companies hire the cheapest resource. I hire the best resource. If you want a company of superstars, you can't pay them $3 (per hour) for a project manager or 50 cents for an engineer. Yes, sometimes they manage to get code developed for crazy low prices. They have interns working on their projects."

The other issue is that of the cost associated with the project or transaction: management, communications, travel, legal counsel and the energies focused on enforcing IPR and other expenses that can occur should things go awry — in other words, the total cost of engagement (using a phrase from Ian Marriott of Gartner).

For example, Wicresoft, a joint venture between Microsoft and the Shanghai Municipal government, according to an article in The Wall Street Journal, hired 10 email "polishers" to teach their Chinese co-workers about American email protocol and "help polish the wording to sound more colloquial." The polishers account for 15% of the total personnel cost of the venture's 100-person US online-service department.

This is not to say that China is not cheap nor fertile land to go for IT services. It simply means that its difficulty or cost should not be — as with any other endeavors in China — underestimated.

A Recap

If you add up the dangers and benefits of outsourcing to China, you get a fairly mixed report card.

(+) We score service provider availability a positive. There are some true diamonds with potential to grow, given the projects. The challenge is finding the company that's appropriate for you to work with.

(~) We score personnel talent and experience neither a negative nor a positive. The right managers — strong in staff development and retention skills — can work wonders.

(-) Intellectual property rights gain a negative mark across the board. If your business is IP-sensitive, you'd better be IP savvy too, to protect what's yours.

(-) Regarding English language skills, we give a negative rating because the results of all that educational effort are uneven. Until students have an on-going opportunity to converse with native English speakers, they'll never achieve the proficiency in the language that most non-China companies need.

(-) Cultural issues gain a negative too, at least until US and European managers have more experience in working within the bounds of the Chinese culture.

(+) The Chinese government's support in taxation and other areas is a positive. We give this a plus — though with the caveat that governmental support in China can be fickle. One day they're wooing your business; the next day, they're turning a blind eye to vigilante justice, as the Japanese recently experienced in multiple Chinese cities.

What are we left with this year? Two positives, three negatives, and a neutral. The year of the dragon comes up next in 2012. And that's the year we predict that China could become a mainstream operator in outsourcing. Until then, to pursue China with your services work, you'd better define yourself as a risk-taker.